Do Oil and the Market Still Have a Lot of Downside?

The EIS portfolio is now substantially out of the stock market and in cash. What sort of an energy investment strategy is cash? It’s the strategy you might want to employ when you judge that

1. All stocks are likely to decline, taking energy stocks down with them, or

2. Oil and/or gas have become short term overpriced and are likely to correct , or

3. Energy stocks have run so far that they’ve become severely overpriced.

I’ve come to judge that #1 above - the risk of a general market crash taking down all stocks - is becoming too great to ignore. I judge #2 - overpriced energy commodities - is a realistic risk for natural gas and a possible risk for oil. And if the commodities do decline significantly over the next 6 - 12 months along with the bulk of stocks, I think that energy equities that look cheap now would likely become even cheaper.

Here’s why I’ve reluctantly come to believe the above is true:

Over the past few years energy stocks have seen some severe pullbacks, but only during the roughly 50% oil price retrenchment from $78 in August ‘06 to $49 in January ‘07 was there a sustained loss of value for energy stocks. Other sharp corrections reversed quickly. The past couple of weeks have been brutal for energy stocks and have seen only modest “dead-cat” bounces to assuage the pain.

This action of energy stocks over the past two weeks is like the post-August 2006 period, suggesting that the oil price may have a good deal further to fall. A 50% oil price retrenchment of the gain from $49 to $147, similar in size to the one in 2006 would bring the price to just under $100. If you assume that the SemGroup (SGLP) bankruptcy artificially took oil from about $130 to $147 and that the real top was about $130, then a 50% retrenchment would bring the oil price to about $90. Natural gas, which actually gained more than oil in 2008 until recently faces increasing North American supplies so has less fundamental support than oil.

The recent decline in oil stocks seems unjustified on fundamentals. While the oil price did fall over $20 from $147, which is not nothing, analysts’ earning estimates for E&P’s for example are based on conservative oil price estimates in the $80 - $100 range, well below today’s price of over $120. The largest drilling company, Transocean (NYSE:RIG) is estimated to earn over $14 this year and $17 next, with further gains extremely visible based on long term contracts. Does that make its $135 share price too high? A bubble? Clearly not. So the substantial declines in energy stocks seem to be anticipating further significant reductions in oil and gas prices and perhaps further weakening of the global economy, not any speculative pricing based on current fundamentals.

If recent weeks’ energy stock losses were simply a severe correction only in energy stocks, this might well be a buying opportunity for the group. But such is not the case. Rather, this energy correction comes in the context of a general market decline that has been eating away at portfolio values almost continuously since August of 2007 . The combination of dramatic losses in energy stocks, very weak recoveries by them, and the continuing slide in the general market suggests to me a deeper significance than just an ordinary correction in energy stocks. In short, I think the market may be signaling that there is an increasing risk that economic weakness may be spreading geographically and demographically, threatening much more serious losses ahead.

Here are some of the factors that concern me about the American economy:

1. Consumers are still spending despite being squeezed by stagnant wages, higher unemployment, higher food and energy prices, tight credit markets, increasing home foreclosures and, most important, lower home prices. It would not be surprising if we see these factors finally result in much lower consumer spending over the next 6 - 12 months.

2. Banks are starting to look shaky. I read just today of the closing of two small banks. We saw the first “run” on a bank recently as IndyMac went under and the TV carried images of people waiting in line to withdraw funds. Also, I understand that IndyMac’s bankruptcy used up 25% of the funding capacity of the FDIC. A need to shore up the FDIC would put further stress on the banking system which funds it. There has been some talk recently about making sure your bank deposits are safe and that you have no more than the $100,000 FDIC guarantee limit in any one account.

This whole concept of the safety of American banks has not been discussed seriously since the Depression. My feeling is that the American banking system may be a bit closer to widespread public fear than one might think. I sense that the Treasury is very aware of this risk and that its recent rapid Fanny/Freddie actions - anathema to standard Republican philosophy - are a symptom that the Treasury is concerned about containing this potential threat to the public trust.

3. Car sales, which normally decline in a weak economy, are getting a triple whammy from two other sources of weakness: higher oil prices that have crippled the market for high profit larger vehicles and the less noticed depressant of an imminent sea-change in technology as the highly publicized plug-in hybrid electrics [PHEV’s] are scheduled to come to market in 2010. I suspect a lot of people will put off replacing their cars until they can buy these new-technology, more efficient models, a factor that will reduce car sales even more than during a normal recession. Note that Chrysler will no longer lease you a car - the company doesn’t want them back in a few years.

Given the lower car sales and the shift to lower profit small cars, it seems to me that all three American car companies must be seen as potential if not likely bankruptcy candidates over the next 24 months. If even one of them goes under, not to say all three, the effect on consumer psychology would be a further market depressant.

4. Both the financial system and sales of consumer durables is dependent on housing. Note that as house prices decline, more and more houses become worth less than the mortgage on them. Self interest by the “owner” suggests a default on the mortgage when that happens. That is why declining house prices is like stepping on the accelerator of the mortgage default problem in America.

Every aspect of housing continues to decline every month and is projected to keep on this track for many more months. Respected commentators suggest we are perhaps only half way through the decline in home prices. I think this bursting housing bubble is the most important driver for all other economic risk factors. When housing bottoms I think we can start to make progress toward a stabilized and then a stronger economy. But that looks like it might be a 2009 phenomenon at the earliest.

5. The $64 question is whether an American recession (dare we say “depression”?)will be a one-off event or whether it will reverberate to the global economy. Clearly it is morphing to a number of OECD countries now. Also clear is the fact that global strength now comes from the growth of the developing economies, particularly China. Can China keep pulling the world economy ahead?

The Chinese government wants to see growth continue. Just today it signaled a move to loosen credit standards and stop trying to increase the value of the Yuan. We tend to think that whatever the Chinese government wants it can ultimately achieve.

But I must note one concern. China seems to be bumping up against both environmental and energy limits to growth. We all know how filthy and polluted the Chinese air and water are reputed to have become. At some point that will tend to limit growth. But a more immediate concern is their lack of coal and the related lack of electrical generating capacity. Electrical shortages are becoming acute, not only in China but also in other developing countries. It is hard to grow an economy without growing electrical output.

Near Term Oil and Gas Supply Dynamics

The second factor - beyond general economic conditions - that an energy investor must consider is the shape of the markets for oil and gas going forward. If the price of oil and gas goes up from here, that would be a substantial support for energy stocks - although it would further harm the general economy.

I have no doubt, as readers of my site know well, that starting in 2010 and especially after 2012, oil supplies will become substantially constrained. But the period from now through 2010 is much less clear. I’ve often said that if Iraq and Nigeria were to start producing up to capacity, there would be a much lower oil price. Well, Iraq has begun to do that.

In addition to Iraq the next 18 months will see significant expansions in capacity from Saudi Arabia, Libya, and Angola. A recent Wikipedia megaprojects analysis shows comfortable supplies in 2008 through 2010. I do not take such projects as gospel, of course. But all the work I’ve done indicates to me that looking forward ten years at the supply of oil, the only years that have a likely chance to be “easy” are 2008 and 2009.

Another positive factor in the near term oil supply is simply the fact that the oil price has gone so high and has now been notably “high” for several years. As commodity experts say, “the cure for high prices is high prices.” It would not surprise me to see some of that impact over the next 18 months as more rigs and better technologies finally succeed in getting more oil out of older fields than previously.

Of course, there are the well known negatives for the oil supply: the global decline rate of about 3.5 mb/d per year, Mexico, the North Sea, and Nigeria. And now with TNK-BP starting to look like Yukos, which could result in some production declines from this 1.5 mb/d producer, near term Russian oil production is also looking more questionable.

In summary, I think it is clear that we are in a long term bull market for the price of oil. But I think it is equally clear that the market has over-shot due to various speculative influences, not the least of which may have been increased hoarding. As the oil price declines, some national oil companies may become more enthusiastic about selling their oil before the price declines further. Venezuela comes to mind, for example. Such a potential reversal of the trend toward hoarding could push the price of oil even below the long term uptrend line, getting it back to perhaps $75.

At some point, if the oil price declines, the forces of OPEC may try to discipline the seller. Whether OPEC still has that capacity or not is unclear. It might be left to the Saudis to do by themselves. But if a global economic slowdown is raging I think the King, who owes his security ultimately to the U.S., might be quite reluctant to make things worse by cutting off oil supplies.

In Sum

All of the above is intended to demonstrate how an apparently low-probability scenario could come about. Specifically, how in the world could Transocean (RIG) be anything but a screaming buy today at $135 a share? This is a company growing at healthy double digit rates as far as they eye can see and selling for under 10 times current year earnings (not to mention even healthier cash flow).

And the answer is: visualize oil at $75 and the global economy going into the pooper. Financial panics. Personal tragedies. Lower global oil demand than the year before. That could get RIG closer to $100.

I well remember that in 1974 - a year of huge stress in the stock market - a cable television company called Viacom (NYSE:VIA) got down to $2 a share. Its future prospects had not changed; they were still shining bright in the eyes of every analyst who understood the dynamics of the cable world. And yet you could buy the stock for $2. If you had any money.

In January, 2008 I decided to “step aside” from the stock market because the credit crisis was looking more serious. In March I decided - prematurely, I now believe - that our government was doing what was needed to resolve the credit problems and the “all clear” signal could be activated.

I do not like this market timing stuff at all. In fact I hate it. And I could well be wrong in the call I am making. If so, the EIS portfolio will lose some profit opportunities and will under-perform. But it won’t lose real money because of the decision. And if I am right, it will have more funds to buy more Transocean at $100 next year, the equivalent of Viacom at $2 in 1974.